Saturday, November 20, 2010
This Chart Should Worry the Short-Term Hyper-Inflationists:
Inflationists argue that the Fed's continued "printing" of money must lead to inflation--i.e., more dollars chasing fewer goods equals higher prices. But, that's not necessarily so since the Fed isn't actually printing anything. We constantly here about "Helicopter Ben Bernanke" being able to "drop dollars from helicopters" at will, but that's not actually how the Fed acts (or can act). Rather, the Fed can only indirectly to impact money supply by seeking to expand the amount of credit in the system, which it has tried to do with all its might for two years now without much success.
The Fed influences the amount of credit in the system by purchasing US Government securities (or in extreme cases other assets) with money that it is legally allowed to create from thin air. But this money doesn't belong to the US government or the private sector free and clear (as if it had been dropped on them from a helicopter). Rather, the bond that the government sold in exchange for the money must one day be repaid to the Fed with interest. So, all the Fed has accomplished in buying the bond is to increase the total amount of debt outstanding in the system beyond the level it would have been without the Fed's intervention.
That's all well and good, but it doesn't necessarily expand the amount of money/credit in the system to inflationary levels--that is, it doesn't necessarily result in more dollars/credit chasing the same amount of goods. For instance, as Robert Prechter has noted, between September 2008 and June 2010 (or the period of QE1), the Fed purchased $2.46 trillion of bonds with money that it manufactured out of thin air. And yet, this increase by Fed was more than completely offset by deleveraging in the private sector such that total US debt outstanding declined by nearly $300 billion during the period. In other words, the private sector paid down or wrote off nearly $2.75 trillion of debt during a period when the Fed was only able to "create" $2.46 trillion of new debt to offset it. And, this decline in total debt was mostly attributable more attributable to write-offs than debt being paid down.
Furthermore, the Fed's ability to purchase debt is not unlimited. There are practical, and more importantly political, constraints that limit just how much government debt it can purchase.
In short, QE1 failed to inflate the economy, and there's no reason to think QE2 will turn out differently. In fact, there are reasons to think the opposite, such as the chart above comparing US core inflation since the start of the burst of its real estate bubble in 2004 to Japan's core inflation since the start of the burst of its own real estate bubble in 1989. Like the US, Japan has engaged in "quantitative easing" many times over the last decade (and on a scale that dwarf's the US's), with the only result being...disinflation and even deflation, not inflation. This is because Japan's private sector deleveraged at a faster rate than the government could sell debt to Japan's central bank to offset it. The same thing is now happening in the US, and based on the above chart, the US appears to be right on track for a "lost decade" of deflation like Japan.
And, this is what one would expect when debt has reached a saturation point. With total US debt around 300 percent of GDP, debt servicing cost is a great burden even with crazy-low interest rates. The private sectors isn't clamoring for more loans these days, not matter how cheap the Fed makes them. It realizes that even a minor shock to the system, such as interest rates returning to the rather modest early 1990's level, would be enough to trigger massive defaults and involuntary deleveraging throughout the system. The only way to protect themselves is to hoard cash, which is exactly what both corporations and private individuals are doing. Hoarding and/or loan defaults can only be deflationary as less money/credit chasing the same amount of goods/assets must ultimately mean lower prices.
We are constantly told in the press that deflation is bad--far worse than inflation in fact. But I suppose that depends on who you are. If you are a banker who has overextended credit, you'd (contrary to popular belief) much prefer moderate inflation to moderate deflation. With inflation, the bank is at least likely to get repaid, albeit with less valuable dollars. The lower value of the repaid dollars will reduce the net rate of interest that the bank originally anticipated earning, but at least it gets repaid! Like all lenders, banks are concerned about the return on their money, but they are even more concerned about the return of their money. Inflationary environments typically result in fewer loan defaults than deflationary ones, which is one reason why Central banks, contrary to popular belief until recently, seek to create modest inflation rather than prevent it.
But, if you are an over-extended debtor, a deflationary environment is far better. Deflation will lower interest cost and reduce your debt burden. Deflation lowers your operating costs or cost of living over time. And if you're one of the unfortunate ones who gets laid off or goes out of business, your debts will (painful as it is) be forgiven in bankruptcy and you'll get a fresh start (a la General Motors).
In short, when credit has been overextended as it undoubtedly has over the last 15 years, inflation benefits bankers and hurts debtors, and vice versa for deflation. This explains why the Fed desires inflation. Fortunately, if Japan is any example, it will fail.
UPDATE:> For another look at just how ineffective the Fed has been at increasing money supply despite all its "money printing", see the blue line on this chart.
ANOTHER UPDATE:> Annual core US inflation drops to lowest rate ever in October.
YET ANOTHER UPDATE:> This video pretty much explains things in an informative and highly entertaining way: